11Long-Term Financing

11.1Basics of Long-Term Financing

Types of Long-Term FinancingCommon stockLong-term debtPreferred stockLeasingOption-type security

WarrantConvertible

Factors Influencing Long-Term Financing Decisions

Target capital structureMaturity matchingInterest rateThe firm’s current and forecasted conditionsOther factors

11.2Common Stock

Common StockCommon stock means different things to

different people, but it is usually applied to stock that has no special preference either in receiving dividends or in bankruptcy.

The common stockholders are the owners of a corporation.

Legal Rights and Privileges of Common stockControl of the firm

The stockholders have the right to elect the firm’s directors, who in turn elect the officers who manage the business.

The problem of control has become a central issue in finance in recent years.

The Preemptive RightA provision in the corporate charter or bylaws that

gives common stockholders the right to purchase on a pro rat basis new issues of common stock or convertible securities.

Other rights and privileges

Major Advantages of Common Stock FinancingThere is no obligation to make fixed

payments.Common stock never matures.The use of common stock increases the

creditworthiness of the firm.Stock often can be sold on better terms than

debt.

Major Disadvantages of Common Stock FinancingThe costs of stock financing are high.Using stock can raise the firm’s cost of

capital.Dividends paid on common stock are not tax

deductible.It extends voting privileges to new

stockholders.New stockholders share in the firm’s profits.

The Market for Common StockOrganized security exchange marketOver-the-counter market

Types of stock market transactionTrading in the outstanding shares of

established, publicly owned companies: the secondary market

Additional shares sold by established, publicly owned companies: the primary market

New public offerings by privately held firm: the primary market.

The Investment Banking ProcessRaising capital: Stage I decisions

Amount to be raisedTypes of securities used.Competitive bid vs. negotiated deal.Selection of an investment banker.

Raising capital: Stage II decisionsReevaluating the initial decisionsUnderwritten issuesIssuance costsSetting the offering price

Selling procedures

11.3Long-Term Debt

Debt InstrumentsTerm loans – a long-term debt contract under

which a borrower agrees to make a series of interest and principal payments on specific dates to the lender.

Bond – a long-term under which a borrower agrees to make a series of interest and principal payments on specific dates to the holder of the bond.

Bond RatingBond ratings are based on both qualitative and

quantitative factors, including the financial strength of the company as measured by various ratios, collateral provisions, seniority of the debt, restrictive covenants, provisions such as a sinking fund, litigation possibilities, regulation and so on.

Bond ratings are important both to firms and to investors.Indicate its default risk and influence the bond’s interest

rate and the firm’s cost of debt.Institutional investors are restricted to investment-grade

securities.Changes in a firm’s bond rating affect both its ability to

borrow long-term capital and the cost of that capital.

11.4Hybrid Financing

Preferred StockA hybrid security having characteristics of debt

and equity.Similar to debt: it has a claim on the firm’s earnings

ahead of the claim of the common stockholders.Similar to equity: debtholders have a prior claim on

the firm’s income and assets.Major provisions

Priority to assets and earningsPar valueDividendsConvertibility

Pros and Cons of Preferred StockPros

Preferred dividends are limitedFailure to pay preferred dividends will not

bankrupt the firmCons

The cost of preferred stock is higher than that of a debt because preferred dividends payments are not tax deductible.

Leasing A means of obtaining the use of an asset without

purchasing the asset.Leasing is similar to a loan and is used by financial

managers as an alternative to borrowing to purchase fixed assets.

Types of leaseSale and leaseback - an operation whereby a firm sells land,

buildings or equipment and simultaneously leases the property back for a specified period under specific terms

Operating lease – a lease under which the lessor maintains and finances the property.

Financial lease – a lease that does not provide for maintenance services, is not cancellable and is fully amortized over its life.

OptionA contract that gives the option holder the

right to buy or sell an asset at some predetermined price within a specified period of time.

Option features are used by firms to “sweeten” debt offerings.

Option-type securities, particularly warrants and convertibles, are attractive to investors because they allow debtholders to acquire common stock at bargain prices and thus to share in the capital gains if a company is especially successful.

WarrantA long-term option to buy a stated number of

shares of common stock at a specified price.A warrant will be exercised if it is about to

expire and the stock price is above the exercise price.

Convertible A security, usually a bond or preferred stock,

that is exchangeable at the option of the holder for the common stock of the issuing firm.

Conversion ratio (CR) is the number of shares of common stock that can be obtained by converting a convertible bond or a share of convertible preferred stock.

Conversion price = Par value of bond / CR